What is Dividend Yield?

The dividend yield, expressed as a percentage, is a financial ratio that presents the amount a company pays in dividends each year relative to its stock price. The reciprocal of the dividend yield is the dividend payout ratio. This article discusses what does dividend yield mean and what is dividend yield in the share market.

What is dividend yield?

The dividend yield meaning specifies that it is an estimate of the dividend-only return of a stock investment. The dividend yield will rise when the price of the stock falls. Conversely, it will fall when the stock price rises. Mathematically, dividend yields change relative to the stock price, and they can often look unusually high for stocks falling in value quickly.
 

What is dividend yield in stocks: Understanding dividend yield

New and relatively smaller companies that grow quickly may pay a lower average dividend than mature companies in the same sectors. Generally, mature companies that do not grow quickly pay the highest dividend yields. Consumer non-cyclical stocks that market staple items or utilities are examples of entire sectors that pay the highest average yield. Although the dividend yield among technology stocks is lower than average, the same rule that applies to mature companies also applies to the technology sector. 

For example, as of June 2021, Qualcomm Incorporated, an established telecommunications equipment manufacturer, had a trailing twelve months dividend of $2.63. Using its current price of $144.41 on August 17, 2021, its dividend yield would be 1.82%. Meanwhile, Square Inc., a relatively newer mobile payments processor, pays no dividends.
 

Calculating the Dividend Yield

The formula for dividend yield is as follows:

Dividend Yield = Price Per Share/Annual Dividends Per Share

One can calculate the dividend yield based on the previous year's financial report. These reports are acceptable during the first few months after the company has released its annual report. However, the longer it has been since the annual report, the less relevant that data is for investors. Alternatively, investors can add the last four quarters of dividends, which captures the trailing 12 months of dividend data. A trailing dividend number is acceptable, but it can make the yield too high or low if the dividend has recently been cut or raised.

As dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as the annual dividend for the yield calculation. This approach will reflect any recent changes in the dividend, but not all companies pay an even quarterly dividend. 

Some companies also pay a dividend more frequently than quarterly. A monthly dividend could result in a lower dividend yield calculation. When calculating the dividend yield, an investor should look at the history of dividend payments to decide which method will give the most accurate results.
 

Example of Dividend Yield 

Suppose company A’s stock is trading at INR 20 and pays its shareholders annual dividends of INR 1 per share. Suppose Company B's stock is trading at INR 40 and pays an annual dividend of INR 1 per share. 

This means Company A's dividend yield is 5% (INR 1 / INR 20), while Company B's dividend yield is only 2.5% (INR 1 / INR 40). Assuming all other factors are equivalent, an investor looking to use their portfolio to supplement their income would likely prefer Company A over Company B considering the double dividend yield.
 

Advantages of dividend yield

A prominent advantage of dividend yield is compounding. Historical evidence suggests that focusing on dividends may amplify returns rather than slow them down. For example, suppose an investor buys INR 10,000 worth of a stock with a dividend yield of 4% at an INR 100 share price. This investor owns 100 shares that all pay a dividend of INR 4 per share (100 x INR4 = INR 400 total). 

Let’s assume that the investor uses the INR 400 in dividends to purchase four more shares. The price would be adjusted on the ex-dividend date by INR 4 per share to INR 96 per share. Reinvesting would purchase 4.16 shares; dividend reinvestment programs allow for fractional share purchases. If nothing else changes, the next year, the investor will have 104.16 shares worth INR 10,416. 

The investor can reinvest more shares once the company declares a dividend, thus compounding gains similar to a savings account.
 

Disadvantages of Dividend Yields

1.    Lack of investments

While high dividend yields are attractive, they may be at the expense of the potential growth of the company. Every rupee a company is paying in dividends to its shareholders is a   that the company is not reinvesting to grow and generate more capital gains. Even without earning any dividends, shareholders can earn higher returns if the value of their stock increases while they hold it as a result of company growth.

2.    Erroneous information 

Investors should not evaluate a stock based on its dividend yield alone. Dividend data can be old or based on erroneous information. Many companies have a high yield as their stock falls. If a company's stock experiences enough of a decline, it may reduce the dividend amount or eliminate it.

3.    Denominator effect

Investors should exercise caution when evaluating a company that looks distressed and has a higher-than-average dividend yield. As the stock's price is the denominator of the dividend yield equation, a strong downtrend can dramatically increase the calculation's quotient.

Dividend yield vs. dividend payout ratio

When comparing corporate dividends, it is important to note that the dividend yield presents the simple rate of return as cash dividends to shareholders. However, the dividend payout ratio represents the company's net earnings paid out as dividends. 

While the dividend yield is the more commonly used term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company's cash flow. The dividend yield shows how much a company has paid out in dividends over a year. The yield is presented as a percentage, not as an actual rupee amount. This makes it easier to see how much return the shareholder can expect to receive for every rupee they invest.
 

Is a high yield always best?

The biggest misconception about dividend stocks is that a high yield is still good. Many dividend investors choose a collection of the highest dividend-paying stock and hope for the best. For several reasons, this is not always a good idea. 
    
A dividend is a percentage of a business’s profits that it pays to its shareholders in cash as its payout ratio. Any amount paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of its profits, it may be a sign that management prefers not to reinvest in the company, given the lack of upside. Therefore, the dividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch. It is a sign that a dividend payer still has the flexibility to reinvest and grow its business. 

Some market sectors have a standard for high payouts, and it's also part of the sector's corporate structure. Real estate investment trusts (REITs) and master limited partnerships (MLPs) are two examples. These companies have high payout ratios and dividend yields because their structure is ingrained.
 

The bottom line

Many stocks pay dividends to reward their shareholders with sound financial footing. The dividend yield measures the number of a company's dividends relative to its share price. High-yielding dividend stocks can be a good buy for some value investors. Yet, they may also signal that a stock's share price has recently fallen by quite a bit, making the legacy dividend comparatively higher than the share price. A high dividend yield could also suggest that a company is distributing too many profits as dividends rather than investing in growth opportunities or new projects.